Washington and Lee Law Review

Volume 40 | Issue 2 Article 4

Spring 3-1-1983

Origins Of Tax Law: The History Of The PersonalService CorporationJ. Timothy Philipps

James S. McNider, III

Daniel E. Riley

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Recommended CitationJ. Timothy Philipps; James S. McNider, III; and Daniel E. Riley, Origins Of Tax Law: The History OfThe Personal Service Corporation, 40 Wash. & Lee L. Rev. 433 (1983),https://scholarlycommons.law.wlu.edu/wlulr/vol40/iss2/4

ORIGINS OF TAX LAW: THE HISTORYOF THE PERSONAL SERVICE CORPORATION

J. TIMOTHY PHILIPPS*

JAMES S. McNIDER, III**

DANIEL E. RILEY***

I. INTRODUCTION

The study of federal tax law involves an understanding of the manyfactors which interact to make our law. While the primary purpose ofthe tax law is to collect the money necessary to run the government, anincreasingly important collateral motivation underlying the enactmentof tax laws involves the desire to use the law as a vehicle for effectuatingcertain social goals.'

In the environment of these motivating elements, taxpayers mustrespond to the rules established by Congress that are interpreted in aprocess involving both the administrative sector of the government andthe courts. As a consequence of the competing considerations underlyingthis process of creating, interpreting and enforcing the tax laws, incon-sistent policies sometimes become evident. Reconciliation of these incon-sistent policies is often made by administrative or judicial compromises.2

One area of tax law that illustrates a process involving inconsistentrules concerns the personal service corporation (PSC). This article willreview the history of the PSC and analyze its tax treatment in an at-tempt to provide a student of tax law with a perspective into the work-ings of the federal tax system. The topic represents a unique confluenceof fundamental substantive issues in the context of frequent legislative,administrative, and judicial activity. The latest example of this activityis the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), astatute which will have a significant impact in amending many of the sec-tions of the Internal Revenue Code of 1954 (Code) that govern the taxtreatment of PSC's.

* Professor of Law, Washington and Lee University. B.S. 1962, Wheeling College; J.D.

1965, Georgetown University; LL.M. 1966, Harvard University.** Associate, Kaufman and Canoles, Norfolk, Virginia; B.S. 1978, Washington and Lee

University; J.D. 1981, Washington and Lee University.*** B.A. 1974, St. Alphonsus College; M.Ed. 1976, Edinboro State College; second year

law student, Washington and Lee University.I One example of the use of the tax laws to achieve certain social goals is the enact-

ment of the rehabilitation tax credit with the Economic Recovery Tax Act of 1981 (ERTA).Pub. L. No. 97-34, § 212(b), 95 Stat. 172 (1981) (codified at I.R.C. § 48(g)).

See infra text at Part H (The History of the Personal Service Corporation).Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324

(1982) (TEFRA).

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A PSC is an entity organized under the applicable state corporationlaw statute, the primary activity of which is to sell the services of in-dividuals.4 The extreme example of a PSC is one which has one person asboth the corporation's sole shareholder and its only employee.5 It is thistype of PSC upon which this article will focus.

Three areas of tax benefits are available to a service-provider whoincorporates instead of operating as a sole proprietorship. The firstbenefit is the ability to shift the taxation of income from the individualtax rates to lower corporate tax rates.' This advantage, however, onlybenefits an individual who causes the PSC to retain and accumulatesome of its earnings, instead of distributing all of its income as deducti-ble expenses.'

The second benefit available to an individual who performs servicesas an employee of a PSC involves tax law provisions that establish cer-tain fringe benefits available to "employees" but not to self-employed in-dividuals.' Thus, in the context of a PSC, the shareholder-employee canprovide for personal expenses to be paid and deducted by his employerand have the benefit excluded from his taxable income by virtue of hisstatus as an "employee."9

The third benefit of a PSC concerns timing differences in therecognition of income. A fundamental concept in tax planning is that a

Most personal service corporations are chartered under the particular state's stockcorporation act or under the state's professional corporation act. For examples of state pro-fessional corporation statutes, see VA. §§ 13.1-543 to -556 (Supp. 1982); N.Y. Bus. CORP. LAW

§§ 1501-1516 (McKinney Supp. 1982-83); CAL. CORP. CODE §§ 13401-13410 (West Supp. 1982).1 The Internal Revenue Service has directed its attacks on the tax status of personal

service corporations primarily toward corporations owned by one person. A common asser-tion of the Service is that income the corporation purportedly earns actually is earned by itssole shareholder. In the context of corporations with two or more shareholders, the attemptedallocations of corporate income to multiple shareholders is made less frequently because anarm's length pooling of income has occurred. See Bittker, Professional Associations andFederal Income Taxation: Some Questions and Comments, 17 TAx L. REV. 1 (1961).

' The average tax rate for a corporation's first $100,000 of income during 1982 is 261/4% for taxable years beginning in 1982. A single individual's average tax rate for the first$100,000 of taxable income is approximately 41% for calendar year 1982. Under theEconomic Recovery Tax Act of 1981, both individual and corporate tax rates decreased fortaxable years beginning in 1983.

Even if a shareholder-employee causes a personal service corporation (PSC) todistribute all of its income in deductible expenses, providing services through a corporationnevertheless can be advantageous because the corporation can deduct certain expenses thata self-employed individual cannot deduct. See infra note 8.

8 Benefits available to an employee but not to a self-employed individual include groupterm life insurance, a medical reimbursement plan, and a $5,000 death benefit. See I.R.C.§ 79 (life insurance); id. § 105 (medical); id. § 101 (death benefit). See also Zalutsky, Com-parison of a Professional Corporation With an Unincorporated Practice After ERISA, 34INST. FED. TAX'N 1355, 1356 (1976); Popkin, The Taxation of Employee Fringe Benefits, 22B.C.L. REV. 439 (1981).

' See Zalutsky, supra note 8, at 1356.

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taxpayer's wealth can be increased to the extent the payment of incometax otherwise immediately payable is postponed." In a PSC, corporateincome taxes may be deferred by the judicious selection of its fiscalyear." Individual income taxes of the shareholder-employee may bedeferred with compensation arrangements whereby income earned onbehalf of the PSC is held in the corporation for a period of time before itis distributed to the shareholder-employee. 2

Until the enactment of TEFRA, one of the most attractive aspects ofa PSC was that a shareholder-employee could defer more income taxunder a corporate employee retirement plan than an individual coulddefer under a self-employed retirement plan." By 1984 TEFRA willeliminate this gap between deductions available under corporateemployee plans and self-employed individual plans, and thereby willdecrease the prior incentive to incorporate. An understanding of thishistorical differential is important, however, since it constituted the

11 See Blum, An Introduction to the Mathematics of Tax Planning, 57 TAXES 707, 708

(1979).1 See Report of Committee on Special Problems of Executives and Professionals, Pro-

bate and Trust Division, Section of Real Property, Probate and Trust Law (ABA), CurrentProblems for Incorporated Professionals, 17 REAL PROP. & TR. J. 357, 357 (1982).

"' See Eaton, Professional Corporations and Associations in Perspective, 23 TAx L.REV. 1, 23 (1967). The most simplistic form of income deferral between a corporation and thecorporation's shareholder-employee involves postponing the distribution of corporate in-come earned at the beginning of the taxable year until the end of the taxable year. Anothermethod of deferring individual income tax on corporate distributions concerns accumulatingthe corporate income during more than one corporate taxable year. The accumulated earn-ings tax imposed under Internal Revenue Code (I.R.C.) § 531, however, limits the amount ofcorporate earnings that a corporation may hold.

s Before Congress enacted the Self-Employed Individual's Tax Retirement Act of1962 (often referred to as the Keogh Bill or H.R. 10), the tax laws prohibited self-employedindividuals from deferring portions of their taxable income by contributing to a retirementplan. Pub. L. No. 87-792, 76 Stat. 809 (1962). The law's discriminatory treatment resultedfrom the common law rule that a sole proprietor acted in his individual capacity and,therefore, could not be an employee of himself. The enactment of the Keogh Bill, however,did not result in equal treatment of employees and the self-employed individual. Thepassage of the Employee Retirement Income Security Act of 1974 increased thediscriminatory manner in which the Code's deferred compensation rules treated self-employed individuals. Pub. L. No. 93-406, 88 Stat. 829 (1974). See Lewis & Hevener, Attribu-tion of Income in Personal Service Corporations, 1 VA. TAX REV. 327, 327 n.2 (1981).Although the Economic Recovery Tax Act of 1981 increased the contribution limits forKeogh plans, objectionable discrimination against self-employed individuals remained afterERTA. Lewis, Taxation of Private Pension Plans under T.E.F.R.A.: Keogh Remembered,68 A.B.A. J. 1568, 1570 (1982) [hereinafter cited as Keogh Remembered].

Immediately before Congress enacted TEFRA, the tax law limited contributions to aqualified defined contribution plan to the lesser of 25% of compensation or $45,475. I.R.C.§ 415(c). Under a qualified defined benefit plan, the law limited annual benefits payable tothe lesser of 100% of compensation or $136,425 for life annually, if retirement began at age55. I.R.C. § 415(b).

TEFRA limits annual contributions to defined contribution plans to $30,000. Underdefined benefit plans, TEFRA will limit a participant to $90,000 yearly. TEFRA § 235(a).

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primary motivation in many cases for incorporating a service provider'sbusiness activities.14

Before discussing the history of the PSC, it is appropriate to in-troduce certain sections of the Code, and one of the common law taxprinciples thereunder, that constrain a taxpayer's ability to take advant-age of the foregoing benefits of a PSC. Fundamental to the assessmentof tax, of course, is the existence of a taxpaying entity.' 5 Income produc-ing activities may be performed by, among others, an individual, part-nership, corporation, or trust. 6 Yet, depending upon the characterizationof these entities for federal income tax purposes under Code section7701,17 the income tax attributable to these activities can varysignificantly.

Once the operating entity has been defined under federal tax law,section 61 of the Code and the assignment of income doctrine govern thethreshold question of whether that entity earns income on which taxmay be assessed. The assignment of income doctrine often proves to bean obstacle to an individual who would like to shift the taxability of per-sonal service income to a PSC.'8 The assignment of income doctrine is acommon law tax principle, the statutory nexus of which is section 61,which is founded on the premise that the "true earner" of the income isthe entity to which the income will be taxed29

The assignment of income doctrine, which has been described as"the first principle of income taxation," was set forth in the classicSupreme Court decision of Lucas v. Earl." In Lucas, the individual tax-payer contracted with his wife to pay her one-half of his futureearnings.2 The Supreme Court held that the taxpayer, the true earner,was taxable on the entire amount of his earnings, notwithstanding hiswife's prior legal claim to the one-half interest.' The Court thus

" See Appel & Harris, The Personal Service Company-A Tax Planning Tool, 31 MA-

JOR TAX PLAN. 10-1, at 10-5 (1981) [hereinafter cited as Appel]; Battle, The Use of Corpora-tions by Persons Who Perform Services to Gain Tax Advantages, 57 TAXES 797, 798 (1979).

" Treasury Regulation § 301.7701 contains the rules for classification of organizationsfor tax purposes. Although state law defines the legal attributes of any particular organiza-tion, federal tax law establishes the classes into which organizations fall for purposes offederal taxation. Treas. Reg. § 301.7701-1(c), T.D. 6797, 1965-1 C.B. 553, 554. See generally B.BITTKER, 3 FED. TAX'N INCOME, EST. & GIFTS 90.1 (1981).

11 See generally Freeman, Combining the Use of Corporations, Partnerships, andTrusts to Minimize the Income and Transfer Tax Impact on Family Businesses and In-vestments, 57 TAXES 857 (1979).

" See supra note 15." See, e.g., American Sav. Bank v. Commissioner, 56 T.C. 828 (1971), acq. on other

issues, 1972-2 C.B. 1.," Lucas v. Earl, 281 U.S. 111 (1930). See generally Brown, The Growing "Common

Law" of Taxation, 34 S. CAL. L. REv. 235 (1961).20 Id.

21 Id. at 113-14.' Id. at 114-15.

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established the common law attribution-of-income rule which would provetroublesome for taxpayers utilizing PSC's.'

Section 482 embodies concepts analogous to the assignment of in-come doctrine. Section 482 provides that the Internal Revenue Service(IRS) may apportion income between commonly controlled trades orbusinesses if apportionment is necessary to prevent evasion of taxes orclearly to reflect the income of each of these entities.24 Determiningwhether, under section 482, income is clearly reflected between two en-tities or individuals involves many of the same considerations as identi-fying the "true earner" of income under section 61 and the assignment ofincome doctrine.' Because of the similar concepts under section 482 andthe assignment of income doctrine, both typically are asserted by theIRS when it attacks taxpayers' income shifting.28

Other Code sections which the IRS has applied to taxpayers' at-tempts to avail themselves of the tax planning possibilities of PSC's aresections 269 and 531.1 Section 269 provides that the Secretary of theTreasury may disallow any deduction or credit if a taxpayer acquireddirect or indirect control of a corporation for the primary purpose ofsecuring the benefit of such deduction or credit.' Since many PSC's havebeen formed to permit their shareholder-employees to obtain the benefitof deductions for contributions to retirement plans,' section 269 poten-tially could apply to a PSC depending on the specific circumstances in-volved.

Section 531 imposes a penalty tax on a corporation's accumulation ofearnings and profits beyond those reasonably needed for the corpora-tion's business." The Code, however, establishes that the corporation

23 Id.

24 I.R.C. § 482. Section 482 provides that:

[In any case of two or more organizations, trades, or businesses (whether or notincorporated, whether or not organized in the United States, and whether or notaffiliated) owned or controlled directly or indirectly by the same interests, theSecretary may distribute, apportion, or allocate gross income, deductions, credits,or allowances between or among such organizations, trades, or businesses, if hedetermines that such distribution, apportionment, or allocation is necessary inorder to prevent evasion of taxes or clearly to reflect the income of any of suchorganizations, trades, or businesses.

Id.An allocation by the Commissioner under § 482 will not be set aside unless clearly

shown to be unreasonable, capricious, and arbitrary. See Ballentine Motor Co., Inc. v. Com-missioner, 321 F.2d 796, 800 (4th Cir. 1963).

See, e.g., infra text accompanying notes 95-128.26 See, e.g., Achiro v. Commissioner, 77 T.C. 881 (1981).2 See, e.g., Ach v. Commissioner, 42 T.C. 114 (1964), aff'd, 358 F.2d 342 (6th Cir.), cert.

denied, 385 U.S. 899 (1966).I.R.C. § 269.See Appel, supra note 14, at 10-5.I.R.C. § 531. See generally Cunningham, More Than You Ever Wanted To Know

About The Accumulated Earnings Tax, 6 J. CORP. TAX'N 187 (1979).

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may safely accumulate $250,000 of earnings and profits in corporationsother than certain service corporations."1 For corporations whose prin-cipal function is the performance of services in certain professionalfields, section 535 provides that the corporation may accumulate only$150,000 before such corporations must rely on the firm's reasonablebusiness needs to accumulate more earnings and profits.2

II. THE HISTORY OF THE PERSONAL SERVICE CORPORATION

The history of the PSC can be instructive to students of tax lawbecause it illustrates the process by which tax law is made. In thesimplest view of the process, tax law is made when Congress enactsstatutes to be codified in the Internal Revenue Code,33 the TreasuryDepartment then promulgates regulations, the IRS issues rulings, andcourts interpret all of the foregoing.34 All of these factors naturally arereflected in the history of the PSC. What makes the PSC a rewardingarea of study, however, is that the issues surrounding a PSC contain ahigh concentration of the many statutory and common law conceptsnecessary for the practice of tax law. 5 Moreover, these fundamental con-cepts operate in the context of an ongoing struggle between the Serviceand taxpayers determined to ascertain the limits of legitimate taxavoidance.

3 1

The legal dilemma of whether to tax a PSC on income earned on theactivities of its sole shareholder-employee has arisen largely becausecorporate retirement plans before TEFRA were more attractive thanretirement plans available for self-employed individuals.3 1 It is a com-

s' I.R.C. § 535(c)(2).Id. The minimum accumulated earnings credit allowable for purposes of offsetting

accumulated taxable income under I.R.C. § 535 is $150,000 "in the case of a corporation, theprincipal function of which is the performance of services in the field of health, law,engineering, architecture, accounting, actuarial science, performing arts, or consulting."

" Not all tax law, however, is codified in the Internal Revenue Code. Congress insteadenjoys the alternative of enacting provisions that affect a narrow class of taxpayers andrecords this enactment only in the Statutes at Large. See Note, Tax Equity andAdHoc TaxLegislation, 84 HARV. L. REV. 640, 641 (1971). See generally Surrey, The Congress and theTax Lobbyist-How Special Tax Provisions Get Enacted, 70 HARV. L. REV. 1145 (1957);Cary, Pressure Groups in the Revenue Code: A Requiem in Honor of the Departing Uni-formity of the Tax Laws, 68 HARV. L. REV. 745 (1955).

See generally M. SALTZMAN, IRS PRACTICE AND PROCEDURE (1981).One commentator has stated that the Treasury's handling of professional corpora-

tions since the 1930s is a classic instance of the cumulative reverberation of mistakes. SeeEaton, supra note 12, at 1. The attractiveness of the history of the personal service corpora-tion as a case study in federal tax law is attributable not only to the Treasury's less thanartful handling of PSC's. The strategy of taxpayers when faced with administrative rule-making and courts' responses thereto is an integral part of this case study.

1 Tax avoidance schemes may exact a heavy price under TEFRA's new complianceprovisions, to the extent the IRS successfully attacks them. See Roth, New Penalty Provis-ions and Their Effect On Aggressive Tax Planning, 61 TAXES 52 (1983).

1 See supra text accompanying notes 13 & 14.

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mentary on our tax system that this unnecessary distinction created atremendous incentive to incorporate which, in turn, generated a largeamount of litigation when the IRS began to contest this practice.

The reasons for the employee/self-employed distinction are obscure.Indeed, it may be that there was no reason why such a distinction wasmade when corporate retirement plans were permitted in the RevenueAct of 1921.38 The rationale of provisions in the Revenue Act of 1921 con-tinuing tax-favored treatment to corporate pension plans was "thedesire to improve the welfare of employees by encouraging theestablishment of trusts for their benefit."39 Yet, Congress apparentlygave little thought originally to extending the benefits to the self-employed.

Representative Keogh, the primary advocate for enactment of thepresent day retirement plan provisions for the self-employed, believedthe original omission of self-employed individuals was inadvertent." Thelack of parity after enactment of Keogh's self-employed retirement plan,however, was the result of a deliberate political maneuver by Represen-tative Keogh. Keogh put forth a discriminatory proposal for self-employed retirement plans that avoided parity with the corporate plandeductions because he believed that the limited nature of the tax breakwould enhance its chances of passage." When Congress first enacted theemployee retirement provisions in the early 1920s, few could have fore-seen that by the 1970s the favorable treatment of employees wouldspawn enactment of professional corporation or association statutes inall the states and the District of Columbia.2

In the face of the desirability of shifting business activities to en-tities taxed as corporations, the IRS challenged this practice on twolevels. The Service attempted to treat common law associations of pro-fessionals, such as doctors, as partnerships instead of corporations fortax purposes 3 In the years before state legislatures enacted profes-sional corporation statutes, professionals formed "associations" in lieu ofcorporations because of the ethical and legal requirements that pro-hibited them from incorporating their practices." With respect to in-dividuals who legally could operate within the corporate cloak, the IRS

" See Keogh, Pensions for the Self-Employed, 100 TR. & EST. 175, 175 (1961).*2 See Rice, Employee Trusts Under the Revenue Act of 1942, 20 TAXES 721 (1942).40 See Keogh, supra note 38, at 175.

" See Voluntary Pension Plans by Self-Employed Individuals, 1961: Hearings on H.R.10 Before the Senate Committee on Finance, 87th Cong., 1st Sess. 117, 125 (1961) (statementof Hon. Eugene J. Keogh, Representative in Congress from the State of New York).

42 Mullane & Williams, Professional Organizations-General Coverage, TAX MGMT.(BNA) No. 227, A-1 (1970).

"3 See, e.g., United States v. Kintner, 216 F.2d 418 (9th Cir. 1954)." States typically would not allow professionals such as physicians and attorneys to

practice as employees of corporations. Moreover, ethical considerations such as the ruleagainst fee-splitting presented an obstacle to groups of professionals who, if they practice ina corporation, would by definition pool their income. See Eaton, supra note 12, at 25, 26.

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attacked this practice by invoking the assignment of income doctrineand section 482.45

The early tax law recognized that PSC's represented a special situa-tion. The Revenue Act of 1918 contained a special definition of personalservice corporations and taxed them as partnerships.4 6 The definitionpresciently anticipated problems which would subsequently arise con-cerning attempts by service-providers to assign their earnings to theirPSC's. A personal service corporation was defined in the 1918 RevenueAct as "[a] corporation whose income is to be ascribed primarily to theactivities of the principal owners or stockholders, who are themselvesregularly engaged in the active conduct of the affairs of the corporation,and in which capital (whether invested or borrowed) is not a materialincome-producing factor. ... "'I

The Revenue Act of 1921 eliminated the special statutory treatmentof personal service corporations, except for the purpose of applying theexcess profits tax.48 Thereafter, a PSC was taxed as a corporation. Con-troversy, however, existed as to the proper definition of an "association"for federal income tax purposes. In 1935, the Supreme Court in Mor-rissey v. Commissioner" established the criteria for determiningwhether an unincorporated entity should be taxed on its income as anassociation. In Morrissey, the Court established the "resemblance test"for distinguishing an association from a trust or partnership for federalincome tax purposes?1 Under this test, an unincorporated businessgroup would be taxed as a corporation if the group exhibited the formalcharacteristics of a "corporation" under state law.51 These indicia of acorporation included limited liability, centralized management, freetransferability of interests, and continuity of life of the enterprise. 52

The year after Morrissey was handed down, the IRS published itsposition that the service would apply the resemblance test on a nation-wide basis.5 In an attempt to enlarge its tax base during the Depression,the government was trying to force association status on organizationssuch as business trusts and limited partnerships. 4 The incentive to taxincome under the more burdensome corporate rate structure, however,ended in the early 1940s.

" See, e.g., Ach v. Commissioner, 42 T.C. 114 (1964), affd, 358 F.2d 342 (6th Cir.), cert.denied, 385 U.S. 899 (1966) (§ 482 case); American Say. Bank v. Commissioner, 56 T.C. 828(1971), acq. on other issues, 1972-2 C.B. 1.

11 Revenue Act of 1918, § 200, ch. 18, 40 Stat. 300.47 Id.41 See Eaton, supra note 12, at 2.11 296 U.S. 344 (1935).s Id.5' Id. at 356-60.5 Id. Also considered as indicia of a corporation under Morrissey were the existence of

associates and carrying on a business enterprise for profit. Id. at 356-59.See Mim. 4483, XV-2 Cum. Bull. 175 (1936); Eaton, supra note 12, at 5.

5, See Eaton, supra note 12, at 5; Mullane & Williams, supra note 42, at A-5.

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The advent of steeply progressive individual income tax rates underthe Revenue Act of 1942 created the opposite incentive to incorporate. 55

The availability of corporate retirement plans only increased the attrac-tiveness of operating in corporate form.56 Unfortunately for the IRS, thegovernment had recently been successful in Pelton v. Commissioner,7

where the Service asserted that a medical clinic with three physiciansdoing business under a trust form was actually an association whichshould be taxed as a corporation.5 8 The Service subsequently was sad-dled with the Pelton decision when it revised its position in the 1950sand began to assert that associations of professionals could not be taxedas corporations. 9

In the face of Pelton, the government lost in United States v. Kint-net 6

0 when the Service argued that a Montana common law association ofphysicians could not adopt a pension plan.6 1 Undaunted by the Kintnerdefeat, the IRS asserted in Revenue Ruling 56-2362 that a group of doc-tors who adopt the form of an association in order to obtain the benefitsof a corporate pension plan should be taxed as a partnership.

The following year, the IRS revoked Revenue Ruling 56-23,5 but theTreasury in 1960 adopted regulations that administratively would over-rule the holding of the Ninth Circuit in Kintner.4 These regulations,aptly referred to as the Kinter regulations, effectively precluded part-nerships and unincorporated business groups from being taxed as cor-porations."' Stung by the Service's unvarnished attempt at legislation byadministrative edict, professionals caused state legislatures to enactstatutes authorizing professionals to incorporate.6 By 1970, forty-ninestates had statutes permitting professional corporations orassociations. 7 Currently, all states and the District of Columbia have oneof these statutes in force. 6

The move by the states to enact professional corporation statutesprompted the Service to respond with new regulations in 1965 which

55 See Eaton, supra note 12, at 5; Mullane & Williams, supra note 42, at A-5.5 Id.

" 82 F.2d 473 (7th Cir. 1936).Id. at 475.

s See Eaton, supra note 12, at 6.216 F.2d 418 (9th Cir. 1954).Id. at 421.

62 Rev. Rul. 56-23, 1956-1 C.B. 598, revoked, Rev. Rul. 57-546, 1957-2 C.B. 886.Rev. Rul. 57-546, 1957-2 C.B. 886.Treas. Reg. §§ 301.7701-1 to -11 (1960).See Zuckman v. United States, 524 F.2d 729 (Ct. Cl. 1975); B. BITTKER & J. EUSTICE,

FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS 2-15 (1979); Scallen,Federal Income Taxation of Professional Associations and Corporations, 49 MINN. L. REv.603, 641 (1964-65).

See B. BITTKER & J. EUSTICE, supra note 65, at 2-20; Scallen, supra note 65, at 605.See B. BITTKER & J. EUSTICE, supra note 65, at 2-20.See Mullane & Williams, supra note 42, at A-1.

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made it practically impossible for a professional corporation to attaincorporate status for federal tax purposes." The government subsequentlylost several attempts to uphold the validity of these regulations." TheService ultimately abandoned its position in 1970 when the Service finallyconceded that professional corporations and associations could be taxedas corporations."

Although the Treasury was unsuccessful in attacking the PSC in theregulations by using a restrictive definition of a corporation for federaltax purposes, the Service has had some success employing the assign-ment of income doctrine and section 482 to undercut taxpayers' effortsto shift personal service income into a corporation. Unfortunately, in thereported PSC cases in which courts have applied the assignment of in-come doctrine or section 482, the courts have failed to agree whether thecommon law assignment of income doctrine established under section 61or the purely statutory section 482 rule should apply to reallocate per-sonal services income in appropriate circumstances.72 The confusion overthe priority between the assignment of income doctrine and section 482is a result of two inconsistent premises in tax law which collide at thepoint of the one-person PSC.

The first premise concerns the principle that an individual must betaxed on the income that person earned.73 The integrity of the pro-gressive tax rate structure depends on the maintenance of this premise,since otherwise it would be possible to split earned income amongrelated parties at will. The second premise involves the recognition ofthe corporation as an entity that can earn its own income through the ac-tivities of its agents.74 When a corporation's only agent is its onlyshareholder, an obvious conflict exists and one premise must be subor-dinated to the other.

The following cases demonstrate a progression in the logic of thecourts. The early PSC cases based their decisions largely on the commonlaw assignment of income doctrine. 75 As will be seen, the recent PSC

69 Eaton & Maycock, Final Professional Corporation Regs are an Improvement-But

Not Much, 22 J. TAX'N 208, 209 (1965).70 See Kurzner v. United States, 413 F.2d 97 (5th Cir. 1969); O'Neill v. United States,

410 F.2d 888 (6th Cir. 1969); United States v. Empey, 406 F.2d 157 (10th Cir. 1969)." Rev. Rul. 70-101, 1970-1 C.B. 278.72 Compare American Say. Bank v. Commissioner, 56 T.C. 828 (1971) (assignment of in-

come doctrine applied) with Rubin v. Commissioner, 429 F.2d 650 (2d Cir. 1970) (§ 482 ap-plied).

" See Lucas v. Earl, 281 U.S. 111 (1930).74 See Rubin v. Commissioner, 429 F.2d 650, 652-53 (2d Cir. 1970). See generally Clark,

The Morphogenesis of Subchapter C: An Essay in Statutory Evoliotion and Reform, 87YALE L. J. 90, 97-100 (1977).

71 The contractual arrangements between a PSC and its shareholder-employee alsohave been held to govern attribution of income issues in PSC cases. See, e.g., Fox v. Com-missioner, 37 B.T.A. 271 (1938). In determining the person or entity to which certain incomewill be taxed, contracts may constitute evidence pointing to the entity that actually earns

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cases have preferred, under certain circumstances, to employ section482 to attribute income to shareholder-employees.7" The utilization ofsection 482 in these recent cases reflects the manner in which courts at-tempt to harmonize conceptually inconsistent rules.

The earliest case to arise in the PSC area was Fox v. Commissioner."The taxpayer there, Fontaine Fox, was a cartoonist and originator of theToonerville Trolley comic strip. Fox caused to be organized an almostwholly owned corporation, the Reynard Corporation (Reynard), whichthen entered into an employment agreement with Fox.78 Under the em-ployment contract, Fox transferred his copyrights to Reynard andagreed to render to Reynard his exclusive services as a cartoonist for aspecified period of time. Reynard subsequently entered into a contractwith a third party, Bell, for syndication of the cartoons. Reynard paidFox a salary of $2,500 per month under this arrangement. The contractbetween Reynard and Bell provided that Bell would pay Reynardamounts far in excess of the monthy $2,500 Reynard paid Fox. For theyear in dispute Bell paid Reynard well over $100,000 while Reynard paidFox a salary of $30,000.78

The Commissioner argued that all the income Reynard receivedshould be taxed to Fox. The Commissioner based this contention on thealternative grounds that (1) the corporation was a mere dummy whose

the income. Taxpayers often argue that they earn income only from their controlled PSCbecause their employment contract requires them to render their services exclusively tothe PSC. Recent cases, however, have disregarded either the contractual arrangements, orthe lack of them, in resolving whether a certain taxpayer earns his income from his PSC ora third party. See, e.g., Foglesong v. Commissioner, 621 F.2d 865 (7th Cir. 1980) (actual per-formance of services exclusively for PSC more meaningful than contract with controlled cor-poration); cf. Johnson v. Commissioner, 78 T.C. 882, 893 n.21 (1982) (employment contractsdo not necessarily determine true earner of income).

Closely related to the issue of whether contract rights may establish the true earner ofincome is the issue of whether personal service income may be taxed to a PSC after itsshareholder-employee assigns a pre-existing employment contract to that entity. Normally,a transfer of "property" (e.g., a contract) will change the person to whom the property's in-come will be taxed. In the area of personal service contracts, however, this rule that incomefrom property is taxed to the property's owner typically does not supercede the commonlaw requirement that the true earner of income must pay the income tax thereon. But seeMcGee v. Commissioner, 81-1 U.S.T.C. 9184 (D.C. Neb. 1980) (transfer of physician's ser-vice contract to controlled corporation transfers taxability of income under contract to cor-poration). Where a person is obligated to work under a personal service contract but has notperformed yet, a better chance exists to shift the tax attributable to the contract proceedsthan if that person had performed before the contract was assigned.

"' See, e.g., Foglesong v. Commissioner, 621 F.2d 865 (7th Cir. 1980)." 77 B.T.A. 271 (1938)."' Id. at 272. Fox owned 98 shares of the 100 authorized shares of Reynard stock. The

corporation issued the remaining two shares to Fox's attorney and his brother, apparentlyto qualify them as directors. Id.

I Id. at 275-76. While Fox's motivations are not entirely clear from the facts, thediscrepancy between Reynard's earnings and Fox's salary indicates that at leist part ofFox's motivation was to shift part of his individual income to Reynard.

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separate existence the court should therefore disregard, and (2) Foxmade an invalid anticipatory assignment of income."0 The Board of TaxAppeals rejected both these arguments. First, quoting the SupremeCourt in New Colonial Ice Co. v. Helvering,8" the Board found Reynardhad a separate, independent existence for federal tax purposes."2 TheBoard based this finding on several facts which indicated that propercorporate formalities had been followed, that Fox had an exclusiveemployment contract with Reynard, and that Bell entered into a con-tract with Reynard and Fox. Reynard also carried out other businesstransactions in Reynard's name and Reynard filed income tax returns.The Board summarily disposed of the assignment of income contention,saying that no contractual relationship existed between Fox and Belland, therefore, Fox had no income rights to assign.8 3

The next major case was Laughton v. Commission,84 which involveda corporation (Industries) established for the motion picture actorCharles Laughton. Although Laughton was the beneficial owner of all In-dustries' outstanding stock, Laughton did not actively participate in themanagement of this company and was not a member of the board ofdirectors. In an employment contract, Laughton agreed to devote hisservices exclusively to Industries.85 At this time Laughton had anoutstanding contractual obligation to make three pictures for an Englishfilm company. Laughton assigned the profits from that contract to In-dustries, and transferred his right to ten percent of the gross receiptsfrom the motion picture "The Private Life of Henry VIII" to Industries.Subsequently, Laughton also caused a contract between himself andParamount Studios to be cancelled. Simultaneously with this cancella-tion, Industries entered into a contract with Paramount for the servicesof Laughton. Laughton personally guaranteed that Industries would per-form according to the terms of the Industries-Paramount contract. 8

The Commissioner in Laughton contended that the Service coulddisregard the corporate form on the ground that Laughton organized In-dustries as a mere tax avoidance scheme. The Commissioner furtherargued that the arrangements between Laughton and Industries wereanticipatory assignments of income. The Board of Tax Appeals determin-ed that the issue was "whether the corporation should be recognized ordisregarded as an entity separate and apart from the petitioner."' TheBoard upheld the corporation's separate status for tax purposes saying

Id. at 276-77.

81 292 U.S. 435 (1934).

37 B.T.A. at 276-77.Id. at 277-78.40 B.T.A. 101 (1939), nonacq., 1939-2 C.B. 56, remanded, 113 F.2d 103 (9th Cir. 1940).40 B.T.A. at 103.Id. at 104.Id. at 105.

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that Industries was a separate business organization operated by per-sons other than Laughton and created for valid business purposes. Fur-ther, the Board rejected the Commissioner's assignment of income argu-ment that the corporation, not Laughton, had earned the income, despitethe fact that Laughton personally guaranteed the performance of hisservices under the contract between Industries and the studio.

On appeal,' the Ninth Circuit remanded Laughton to the Tax Courtto determine whether Laughton's hiring of himself to Industries for asalary substantially less than the compensation for which Industries sup-plied Laughton's services as Industries' employee "constituted, in effect,a single transaction by Laughton in which he received indirectly- thelarger sum paid by the producers."89 The Ninth Circuit's remand wasbased upon the fact that the Supreme Court, subsequent to the Board ofTax Appeals decision, decided the case of Higgins v. Smith,1 whichdisregarded the existence of a wholly owned corporation by disallowinga loss on a sale between the corporation and its sole shareholder." Unfor-tunately, there is no report of the Laughton decision on remand.2

The next flurry of activity in the PSC area began with Borge v. Com-missioner.3 Victor Borge, a well-known professional entertainer,operated for several years a separate poultry-raising business as a soleproprietorship. Borge's poultry business had consistently shown losseswhich Borge used to offset his entertainment business income. When thehobby loss provision of former section 270 threatened Borge, he was ad-vised to transfer the poultry business to his newly formed, wholly ownedcorporation (Danica). Borge contracted with Danica to perform entertain-ment and promotional services for Danica over a five-year period. Thecontract set compensation at $50,000 per year. Danica then offset thepoultry losses against the company's entertainment profits, whichprofits far exceeded the $50,000 a year Danica had contracted to payBorge 4 The court found as a fact that Borge would not have enteredinto such a contract with an unrelated party. 5 The court, therefore,upheld the Commissioner's allocation under section 48296 of a portion ofthe entertainment business profits to Borge. The Borge court was in-fluenced by the facts that: (1) Danica had done nothing to further theentertainment business, (2) third parties who contracted with Danica for

Commissioner v. Laughton, 113 F.2d 103 (9th Cir. 1940).Id. at 104.308 U.S. 473 (1940).Id. at 477-78

'3 Bittker, Professional Associations and Federal Income Taxation: Some Questionsand Comments, 17 TAx L. REV. 1, 5 n.8 (1961).

3 405 F.2d 673 (2d Cir. 1968), affg, T.C.M. (P-H) 67,173 (1967), cerL denied, 395 U.S.933 (1969).

" 405 F.2d at 675.'3Id.

Id. at 675-76.

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Borge's services required Borge's personal guarantee on the contract,and (3) Danica underpaid Borge's stipulated salary. 7

Borge represented a fundamentaly new judicial treatment of a PSC.Borge appears to be the first case in which the IRS allocated purely per-sonal service business income to the service-provider solely under sec-tion 482 principles. 8 Despite the court's attention to the formalities ofBorge's arrangements with the corporation, the determinative factor inBorge was that the court believed that Borge formed and operated thecorporation as a tax avoidance device. The court made a specific findingunder section 269 that "Danica was incorporated with the purpose ofevading or avoiding federal income taxes."99

The next significant decision, Rubin v. Commissioner,"' constituteda quantum leap in the Tax Court's approach to the PSC. Rubin, the tax-payer, controlled a manufacturing corporation (Dorman). Along with hisbrothers, Rubin set up a management company (Park). Rubin ownedseventy percent of Park and his brothers owned thirty percent. Themanagement company also engaged in an art business. Park entered intoa contract with Dorman under which Park would manage Dorman forfour years at an agreed compensation, with the understanding thatRubin would personally perform the management services. Rubin signedthe contract as president of Park, although at the time Rubin signed thecontract Park was not yet incorporated. Rubin apparently did not enterinto any employment contract with Park. During the time the manage-ment contract was in effect, Rubin also performed services for someother business entities. Rubin generally recognized the separate ex-istence of Park in its dealings with Dorman, but did not do so with out-side parties."'

The Commissioner, relying on both section 61 and section 482,allocated to Rubin as an individual the management fees which Dormanpaid to Park for the management services."2 The Tax Court found thatthe Commissioner was correct on several grounds. The first ground wassimply substance versus form. Although the court refused to deny thevalidity of Park for tax purposes, the court recognized a distinction be-

"¢ Id. at 675. In the Tax Court, the Commissioner had relied upon both §§ 61 and 482.Both the Tax Court and the Second Circuit in Borge, however, premised their decisions on§ 482 and ignored § 61.

" But cf. Ach v. Commissioner, 42 T.C. 114 (1964), aff'd, 358 F.2d 342 (6th Cir.) (mer-chandising operation rather than purely personal service business), cert. denied, 385 U.S.899 (1966).

" 405 F.2d at 678. Borge's tax avoidance maneuvers succeeded partially since the ser-vice reallocated only a portion of the entertainment business income to him under § 482.The Commissioner had allocated only that portion and had not asked the court for more.The court found the Commissioner's allocation "indeed, generous." Id. at 677.

"' 51 T.C. 251 (1968), rev'd, 429 F.2d 650 (2d Cir. 1970), on remand, 56 T.C. 1155 (1971),aff'd, 460 F.2d 1216 (2d Cir. 1972).

51 T.C. at 263.Id. at 264.

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tween attacking the corporation's validity and attacking the validity ofpurported transactions into which the corporation entered. 3 The Rubincourt reasoned that since Rubin controlled both Dorman and Park, therewas no business purpose in the form used by Rubin. 4

The Tax Court then offered an alternate but "perhaps only seman-tically different" rationale. It said it would have reached the same resultapplying the assignment of income doctrine.' Citing a classic law reviewarticle,0 6 the court asserted that the issue of identifying the appropriatetaxpayer turned on the question of who controlled the earning of the in-come."' The Tax Court found that Rubin "clearly directed and controlledthe earning of the income" because (1) Rubin himself negotiated themanagement services contract before Park was incorporated, (2) Rubinperformed services for other business entities after Park was incor-porated, and (3) Rubin terminated the contract without consultation withor consideration to Park.'

The Rubin court distinguished Laughton and Fox on the ground thatthe taxpayers in Laughton and Fox were contractually bound to renderservices exclusively to the corporation."°' Rubin, on the other hand, re-mained free to (and actually did) engage in other work."0 Rubin's failureto dedicate his services completely to Park influenced the court becauseit indicated that Rubin, and not Park, controlled the earning of income inquestion."' Thus,-the Tax Court in Rubin seemed to require an exclusiveservices contract between the taxpayer and the corporation. The Rubincourt also indicated that the taxpayer should not control both theservice-provider and the recipient of the service."'

On appeal, the Second Circuit reversed and remanded."' The SecondCircuit recognized that loan-out situations create a tension between twocompeting policies of tax law: the recognition of the corporate form onthe one hand, and the principle of a graduated tax rate on the other."'Judge Friendly declared that the Tax Court's inquiry as to the trueearner of income merely restated the issue. According to Judge Friendly,resort to common law doctrine of taxation and the broad application ofsection 61 only occasionally proves useful, and then only when taxavoidance motives not susceptible to other safeguards heavily freight

103 Id.

' Id. at 265.105 Id." Lyon & Eustice, Assignment of Income: Fruit and Tree as Irrigated by the P.G.

Lake Case, 17 TAx L. REv. 295 (1962)."3 51 T.C. at 265-66.106 Id. at 266."3 Id. at 266-67." Id. at 267."' Id.112 Id.

Rubin v. Commissioner, 429 F.2d 650 (2d Cir. 1970)." Id. at 652.

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the transaction."' The Second Circuit held that where a statutory provi-sion adequately deals with the problem, drastic remedies have noplace."6 Therefore, section 482 of the Code was clearly superior to the"blunt tool" the Tax Court employed, since section 482 provided greaterflexibility than the all-or-nothing approach of section 61.11 The SecondCircuit remanded Rubin for consideration of the Commissioner's claimunder section 482.118

On remand, the Tax Court again decided against Rubin."' The factsthe Tax Court used to support its prior holding under section 61 alsoestablished the basis for an allocation under section 482."' Thus, althoughJudge Friendly criticized the use of section 61 in determining Rubin'stax liability, the Tax Court on remand based its decision on the samefundamental substance-over-form principles."' This time, however, theTax Court used the rubric of section 482 rather than section 61.

Rubin set a new judicial course that eventually placed primary em-phasis on section 482. During this period of transition, however, the TaxCourt appeared to waver between relying on section 61 and makingreallocations under section 482. In some cases, section 61 and the assign-ment of income doctrine provided the sole ground for the results; inother cases section 482 was determinative; while in still others the courtrelied on both assignment of income and section 482."'

" Id. at 653.116 Id.117 Id.... Id. at 654."' Rubin v. Commissioner, 56 T.C. 1155 (1971), aff'd per curiam, 460 F.2d 1216 (2d Cir.

1972).,2o Id. at 1162.121 Id. Using § 482, the Rubin court allocated a somewhat smaller portion of the cor-

poration's income to Rubin than the court would have allocated to Rubin under § 61. Under§ 61 the Tax Court upheld a reallocation to Rubin of $25,000 in income and $17,000 in ex-penses for 1960 and $59,000 in income and $17,000 in expenses in 1961. On remand the TaxCourt charged Rubin with net income of $4,400 and $23,500 for the years 1960 and 1961respectively. Id. at 1164.

1" See, e.g., Jones v. Commissioner, 64 T.C. 1066 (1975); Gettler v. Commissioner,T.C.M. (CCH) 442 (1975); Jordan v. Commissioner, 60 T.C. 872 (1973); Estate of Cole v.Commissioner, T.C.M. (P-H) 73,074 (1973); American Say. Bank v. Commissioner, 56 T.C.828 (1971); Roubik v. Commissioner, 53 T.C. 365 (1969). In American Savings Bank the courtrelied solely on the assignment of income doctrine, both parties having expressly disclaimedapplication of § 482. The American Savings Bank paid fees to the PSC of two members ofthe bank's board of directors. The Tax Court attributed these fees to the income of theshareholder-employees, since the shareholders exercised control over both the PSC and thecorporation receiving the service. The court allocated the income to the shareholder-employees even though the court expressly found that the PSC was a valid corporate entity.The American Savings Bank court invoked § 61 and assignment of income principles, andfound that the shareholder-employees actually owned and controlled the income. The courtdistinguished Fox and Laughton since the shareholder-employees did not work exclusivelyfor the PSC, the shareholder-employees controlled both the PSC and the recipient corpora-tion, and the shareholder-employees failed to show that the PSC employed the shareholder-employees or that the shareholder-employees acted as the PSC's agents. 56 T.C. at 841.

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By the end of the 1970s, the courts obviously still had failed to form acompletely satisfying doctrinal basis for dealing with the PSC dilemmaof respecting the existence of the corporate entity while simultaneously

Perhaps the most important fact that the court considered was that the PSC never paid theindividual shareholder-employees any compensation for their services. Id. at 842.

Roubik also turned solely on § 61 and the assignment of income doctrine. In Roubik,several doctors formed a PSC. The court defined the issue as whether the corporation ac-tually carried on the doctors' business or whether the doctors carried on their business out-side the organization. The professional service corporation in Roubik never arranged to pro-vide its employees' services to any of the institutions for which the doctors provided ser-vice. The court found that the relationship between the doctors and their patients was an in-herently personal relationship, and expressed doubt that a professional service corporationcould interfere with such relationships. 53 T.C. at 379. More importantly, the taxpayers failedto treat the corporation as a corporation. The doctors largely ignored the corporate form,followed few corporate formalities, and in the words of Judge Tannenwald's concurringopinion, failed to "put flesh on the bones of the corporate skeleton." Id. at 382. Courts andcommentators have largely dismissed Roubik as representing no more enlightening a princi-ple than that a taxpayer must follow the requisite formalities to obtain recognition of thecorporate status. However, Roubik also manifested the Tax Court's greater willingness toquestion the validity of a PSC than previously manifested in Fox and Laughton.

In Jordan, the Tax Court rested its decision not on § 61 and the assignment of incomedoctrine but rather on § 482. The court rested its decision on grounds similar to the groundsthe Roubik court invoked to allocate income under the assignment of income doctrine. Thecourt found overwhelming evidence that the PSC had no control over the taxpayer's respon-sibility to perform services for which the PSC received income. 60 T.C. at 883. The court alsonoted that the evidence proved that the taxpayer performed services and received commis-sions with little regard to the existence of the PSC. Id. The Roubik court earlier gavesimilar reasons for applying § 61 and the assignment of income doctrine.

In Jones, a court stenographer formed a PSC. The Jones court refused to attribute tothe PSC the income generated when the PSC purportedly contracted out the stenographyservices of the stenographer, its principal shareholder. The court reasoned that thestenographer could not legally delegate stenographic services, and that the corporation car-ried out precisely the identical functions the stenographer previously performed. Of course,most, if not all, solely owned PSC's carry out functions identical to the functions the in-dividual taxpayer previously performed. The Jones court made a feeble attempt todistinguish Fox on the ground the taxpayer in Fox had an employment contract with thePSC, and the PSC contracted with the third parties receiving the taxpayer's services.

One notable taxpayer victory during this period was Gettler. In Gettler, two lawyersand a labor relations specialist formed a PSC to perform labor relations services. The Get-tler court rejected the Commissioner's attempt to allocate income from the PSC to the in-dividuals under either § 61 or § 482. The court supported its decision with several factorsconcerning observance of corporate formalities. For instance, the corporation maintainedseparate books, kept its funds in separate bank accounts, used its own letterhead, and paidsmall annual dividends. Aside from these formalities, however, the corporation's existencewas ephemeral, since the corporation's office was the office of the taxpayers' law partner-ship, the corporation paid the law partnership only $720 a year for rent and for secretarialand accounting services, and the corporation had only three clients, two of whom weresubstantial clients of the law partnership. However, and perhaps most important, the courtfound a valid business purpose for the arrangement.

Another taxpayer victory was Estate of Cole. Cole, a well-known entertainer, madeseveral loan-out arrangements through a series of trusts and corporations. The court refusedto apply either § 61 or § 482 to allocate income from the corporation to Cole. Cole involvedincredibly complicated and perhaps unique facts and the court handed down a memorandumdecision. The decision's precedential value, therefore, is limited.

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protecting the integrity of the progressive tax rates. The disparity inpension treatment between employees and self-employed individuals bythe 1970s led to a situation where individual taxpayers incorporatedthemselves in the hope of shifting their income to their controlled cor-porations. While the courts responded in diverse ways to this shifting ofincome, a halting movement toward judicial dependence on section 482to police the area occurred.

Foglesong v. Commissioner'3 seemed to confirm this judicialmovement towards using section 482 to address the assignment of in-come to PSC's. Foglesong, a sales representative rendering services totwo steel tubing companies, organized Frederick H. Foglesong, Inc.(FHF, Inc.) in which he was the controlling shareholder and soleemployee. Foglesong contributed one hundred percent of the initialcapital to FHF, Inc. and received ninety-eight percent of its commonstock. FHF, Inc. issued the remaining two percent of the common stockto Foglesong's wife and to his accountant. FHF, Inc. issued all of itspreferred stock to Foglesong's four children. During the first four yearsof FHF, Inc.'s existence, the corporation paid no dividends on the com-mon stock but paid dividends in excess of $30,000 on the preferred stock.

FHF, Inc. employed Foglesong to do the same sales work he hadpreviously done in his individual capacity. After incorporation and atFoglesong's request, the companies for which he was sales represen-tative sent his commissions to FHF, Inc. None of the companies executedwritten agreements with FHF, Inc., nor did a written employment con-tract exist between Foglesong and FHF, Inc."4 In the Tax Court, the Ser-vice successfully argued that Foglesong in reality earned ninety-eightpercent of the income FHF, Inc. purportedly earned. Accordingly, underthe authority of section 61 and the assignment of income doctrine, the in-come was taxed to Foglesong.25

The Seventh Circuit, following the lead of Judge Friendly in Rubin,reversed the Tax Court.2 ' The Seventh Circuit held that application ofassignment of income principles in this context effectively disregardedthe corporate existence. The circuit court opinion explained that in lightof Moline Properties,' absent more extreme facts than appeared inFoglesong, the court could not use the assignment of income doctrine toachieve essentially the same results as the court would achieve bytreating the corporation as a sham for tax purposes.'28

123 T.C.M. (P-H) 76,294 (1976), rev'd, 621 F.2d 865 (7th Cir. 1980), on remand, 77 T.C.

1102 (1981), rev'd, 691 F.2d 848 (7th Cir. 1982).' T.C.M. (P-H) 76,294, at 76-1287 to -1289.

" Id. at 76-1289." See Foglesong v. Commissioner, 621 F.2d 865 (7th Cir. 1980).

, Moline Properties v. Commissioner, 319 U.S. 436 (1943) (corporation a viable taxableentity so long as the purpose for its creation is the equivalent of business activity or itscreation is followed by carrying on of business by the corporation).

12 621 F.2d at 869.

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The court found that the absence of a written employment contractbetween the taxpayer and his corporation was immaterial. The SeventhCircuit concluded that Foglesong had in fact worked exclusively for thecorporation, and that Foglesong's arrangement with the corporation wasmore significant than the lack of a written agreement.'29 The courtpointed out that in any situation where a sole shareholder-employee con-tracts with his corporation, the individual can terminate his services bysimply rescinding the contract in his capacity as a corporate officer.Foglesong's use of section 482 was premised on the court's view that sec-tion 482 was a more precise tool than section 61 and the assignment of in-come doctrine. While the Seventh Circuit asserted that the taxpayerengaged in "very aggressive tax avoidance measures" which appear tobe vulnerable, the court insisted "there is no need to crack walnuts witha sledgehammer.""13

On remand to the Tax Court, 3 ' Foglesong argued that the courtcould not apply section 482 to him, because he was a mere corporateemployee and not an organization, trade, or business as required by sec-tion 482. The Tax Court explicitly dismissed the taxpayer's contention"'and then applied an arm's length standard to determine whether or notthe court should allocate the corporation's income to Foglesong undersection 482."' The Foglesong court defined the section 482 determinationstandard as the extent to which the total compensation that FHF, Inc.paid Foglesong exceeded the amount Foglesong would have earned ab-sent incorporation. The Tax Court found that Foglesong received com-pensation far below what he would have received in an arm's lengthtransaction." Therefore, the court refused to tax Foglesong for the in-come. Section 482 thus yielded the same result as the assignment of in-come doctrine. Significantly, the Tax Court in Foglesong specificallystated that it did not intend to discourage PSC's where one of the pur-poses for incorporating was to take advantage of tax law benefits suchas medical reimbursement plans, death benefits, and retirement plans."'

"' Id. at 872." Id. at 872-73.131 77 T.C. 1102 (1981).

"3Id. at 1104."' Id. at 1105.13 Id. at 1106.

"3 On taxpayer's appeal of the remand, a different panel of the Seventh Circuit surpris-ingly held that § 482 was unavailable to reallocate income between Foglesong and his PSC.Foglesong v. Commissioner, 691 F.2d 848 (7th Cir. 1982). The court rejected the Tax Courtposition that being an employee of one's own PSC constitutes a trade or business separatefrom that of the PSC. Id. at 851. Therefore, it found that § 482's two trade or business re-quirements was not satisfied. It distinguished cases such as Borge v. Commissioner, 405F.2d 673 (2d Cir. 1968), cert denied, 395 U.S. 933 (1969), and Ach v. Commissioner, 358 F.2d342 (6th Cir.), cert. denied, 385 U.S. 899 (1966), which had applied § 482 to reallocate incomebetween a corporation and its shareholder, saying that such cases involved situations inwhich the shareholder was actually carrying on a business separate from that of the cor-

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The Tax Court's decision in Keller v. Commissioner'36 foreshadowedthe application of section 482 in Foglesong. Keller, a pathologist, was apartner in Medical Arts Laboratory (MAL), a general partnership com-posed of several pathologists. MAL rendered pathology services tohospitals and physicians. MAL received its technical and laboratory sup-port from Medical Arts Laboratory, Inc. (MAL, Inc.), while MAL provid-ed quality control and superYisory services to MAL, Inc. All of the MALpartners were shareholders and directors of MAL, Inc.'

Keller formed a PSC, Keller, Inc. Keller was the sole shareholder,director, and employee. Keller, Inc. adopted a tax qualified retirementplan and a medical reimbursement plan. An agreement between Kellerand MAL substituted Keller, Inc. as a partner in MAL. Thereafter,Keller, Inc. received Keller's prior share of the income that the partner-ship earned. Keller, Inc. paid Keller an annual salary for his services."

On alternative grounds, the Commissioner sought to tax Kellerdirectly on the income Keller, Inc. received. First, under section 61, theCommissioner sought to hold Keller liable based on the doctrines of lackof business purpose, substance-over-form, and assignment of income.'39

In response to the Commissioner's lack of business purpose and substance-over-form arguments, the court refused to deem efforts to obtain theadvantages of qualified retirement and medical plans by conductingbusiness in the corporate form sufficient to render the taxpayerculpable of illegitimate tax avoidance. The court ignored the issue ofwhether the desire to obtain these benefits comprises a business pur-pose since Keller, Inc. did in fact engage in business activity, ie.,medical services. "" The court reached this conclusion despite the factsthat Keller, Inc. had the same offices as MAL and MAL, Inc., did notpay rent, did not purchase or own property, and did not employanyone but Keller and Keller's wife. The court also refused to acceptthe Commissioner's assignment of income argument. The court decidedthat the assignment of income doctrine, if successful, would renderKeller, Inc. a nullity for federal income tax purposes, a result inconsis-tent with the policy favoring the recognition of corporations as entitiesindependent of their shareholders.'

poration, or in which a taxpayer was attempting to shift losses from one business toanother. Id. at 851-52. The issue of whether being an employee of one's controlled PSC con-stitutes a separate trade or business under § 482 is by no means settled, however, since theTax Court clearly took the opposite position in Keller v. Commissioner, 77 T.C. 1014 (1981)which is currently on appeal to the Tenth Circuit. See 2 ABA Section of Taxation, Newslet-ter No. 2, at 10 (Winter 1983).

77 T.C. 1014 (1981)."' Id. at 1016.

Id. at 1016-17." Id. at 1021.,o Id. at 1023-24..,. Id. at 1031.

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Under section 482, the Commissioner sought to allocate to Keller onehundred percent of the income which Keller, Inc. reported. The courtheld that being an employee of one's own PSC constitutes a separatetrade or business and, consequently, it could apply section 482 in theone person PSC situation."' The court nevertheless found that theCommissioner's attempt to shift all of Keller, Inc.'s income to Kellerunder section 482 was arbitrary and capricious.' The standard thecourt used in testing the employment arrangement was whether bothKeller, Inc. and Keller would have entered into their financial relation-ship if they had been unrelated parties dealing at arm's length. Thecourt inquired whether the total compensation Keller, Inc. paid Keller(including salary, pension plan contributions, and medical expensereimbursements) was substantially equivalent to what Keller wouldhave received absent incorporation. '44

A strongly worded dissent," in which six judges joined, rejectedthe majority's quantification-of-compensation approach. The dissentpointed out that Keller's PSC was basically a paper entity. The PSCowned no medical supplies, office furniture, or technical medical equip-ment. The corporation employed neither medical technicians nornurses. To the dissenters, the corporation was nothing more than abank account through which the taxpayer's income was funneled. As aresult, "the attenuated subtleties triumph over economic substanceand practical reality, and form and artifice reclaims center stage of ourtax laws." ' The dissenters in Keller feared that "[a]fter this decision,anyone may form a corporation, paper the file a little, and market hisservices with his salary being paid to his corporation."'4 7 The dissentingopinion concluded with a ringing defense of the assignment of incomedoctrine and took issue with the Second Circuit opinion in Rubin,which the dissenters believed dealt cavalierly with a fundamentalprinciple in income taxation.148

The competing concepts of the assignment of income doctrine andthe recognition of a corporation as a separate earning entity illustratehow courts fashion compromise from conflict. Judicial resort to section482 in the PSC area exemplifies the manner in which courts reconcile in-consistent premises. Conceptually, the assignment of income doctrinecan operate to tax a sole shareholder-employee on the income his PSCpurportedly earns despite the fact that a corporation generally is aseparate taxpaying entity. In Lucas v. Earl,' the government did not

'4, Id. at 1022-24.

,, Id. at 1025.144 Id.145 Id. at 1035 (Wilbur, J., dissenting).46 Id. at 1039.147 Id.,,' Id. at 1043-44." 281 U.S. 111 (1930).

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contend that Mrs. Earl had no legal existence as a separate taxpayingentity. Rather, the Court simply held that Mrs. Earl did not earn the in-come that her husband assigned to her."' Nevertheless, courts haveoften been reluctant to apply the assignment of income doctrine in PSCcases for fear of eroding the idea of the corporation's separate existencefor tax purposes. The use of section 482 in cases involving one-personPSC's constitutes a judicial compromise in recognition of the competingconcepts of the assignment of income doctrine and the corporation's ex-istence as a separate entity that can earn its own income. By applyingsection 482, courts are able to respect the corporate entity as a distinctearner while simultaneously allocating income from the corporation toits controlling shareholder-employee.

III. THE FUTURE OF THE PSC AFTER TEFRA

In recognizing that a corporation can earn its own income, courtshave used the compromise measure of section 482 to limit the assign-ment of income to PSC's. Once courts decided that section 482 couldpreempt section 61 and the assignment of income doctrine, the results inmany of the PSC cases seemed to have turned on whether the taxpayeroperated the PSC in connection with a "good" or "bad" tax avoidancemotive. In many cases where the taxpayer successfully avoided thereallocation of income under section 482, the principal purpose underly-ing incorporation appeared to be securing the permissible benefit of acorporate deferred compensation plan. Conversely, in many cases whenthe taxpayer was unsuccessful in avoiding reallocation, the taxpayercreated the PSC primarily for "bad" motives such as to split income orutilize losses. 151

In the future, however, taxpayers in many cases will be unable touse a legitimate tax avoidance motive to avoid reallocation of corporateincome to shareholder-employees. Not only does TEFRA eliminate theincremental advantage of a corporate deferred compensation plan,'52 butthe addition of section 269A to the Code by TEFRA5 3 no longerrecognizes the favorable tax treatment of PSC's and their shareholder-employees as a permissible justification for recognizing the PSC as atrue earner of income.

Section 269A provides that the IRS, under certain circumstances,may allocate all income and deductions between "a personal service cor-poration" and its "employee-owners" if such allocation is necessary to

" Id. at 114.

... Compare Borge v. Commissioner, 405 F.2d 673 (2d Cir. 1968) (principal motive of in-

corporation apparently to offset personal service income with corporate losses) with Kellerv. Commissioner, 77 T.C. 1014 (1981) (a principal motive of incorporation apparently to ob-tain tax benefits of employee pension plan).

112 TEFRA §§ 235(a), 238.5 Id. § 250.

[Vol. 40:433

PERSONAL SERVICE CORPORATIONS

prevent avoidance or evasion of federal income tax. Before the IRS canallocate income and deductions under section 269A, two conditions mustbe met. First, substantially all of the services of the personal service cor-poration must be performed for (or on behalf of) one other corporation,partnership, or other entity. Second, the principal purpose for formingthe personal service corporation must be the avoidance or evasion offederal income tax by benefitting any employee-owner in a manner nototherwise available without a corporation. The House-Senate Con-ference Agreement, out of which section 269A was reported, stated that"the conferees intended that the provisions overturn the results reachedin cases like Keller v. Commissioner, 77 T.C. 1014 (1981), where the cor-poration serves no meaningful business purpose other than to secure taxbenefits which would not otherwise be available." '54

By virture of the reduced marginal benefits available to incor-porated service-providers, the enactment of TEFRA likely will decreasethe number of PSC's incorporated in the future. To the extent that in-dividuals desire to form PSC's notwithstanding these reduced benefits,however, the question remains whether courts will subject service-providers who incorporate to a more stringent test under section 269Athan courts in the past applied under section 482 and the assignment ofincome doctrine. While section 482 addresses whether evasion of taxesor a distortion of income occurred, section 269A permits reallocation ifthe principal purpose of a PSC is the avoidance of federal tax.

Despite the ostensibly more expansive reach of section 269A with its"tax avoidance" language, the impact of section 269A on existing lawprobably will be minimal due to TEFRA's establishing parity betweenthe retirement plans available for employees and self-employed in-dividuals. Precisely because the principal purpose for the incorporationof service-providers had been to take advantage of the more attractivecorporate deferred compensation plans, the elimination of this benefitwill mean that the nontax benefits of incorporating will assume greatersignificance in the decision whether to incorporate. As a consequence ofthe enhanced importance of the nontax aspects of incorporating, the Ser-vice will have more difficulty persuading a fact-finder that the principalpurpose of forming a PSC was to avoid federal income tax. In those caseswhere, for example, obvious income-splitting constitutes the motivationfor incorporating a service-provider, section 61 and the assignment of in-come doctrine-even under pre-TEFRA law-would operate toreallocate the income properly. Thus, even when the personal servicecorporation performs substantially all of its services for another entity,section 269A is unlikely to have much impact beyond the present reachof sections 61 and 482.

Section 269A thus illustrates why attempts at a complete statutory

'" H. REP. No. 760, 97th Cong., 2d Sess. 634 (1982).

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456 WASHINGTON AND LEE LAW REVIEW [Vol. 40:433

resolution of any tax problem are likely to be deficient. As the history ofthe tax law amply demonstrates, attempts to legislate general prin-ciples, such as the assignment of income doctrine, inevitably challengethe ingenuity of tax advisors to devise ways to avoid the strictures ofthe statute. Due to the dynamics of tax law evolution and its presentstate in the PSC area, further change is unavoidable.

WASHINGTON AND LEELAW REVIEW

Volume 40 Spring 1983 Number 2

Editor-in-ChiefGAINES H. CLEVELAND

Lead Articles EditorsD. STAN BARNHILL DIANE P. CAREY

Managing Editor Research EditorJOHN M. BLOXOM, IV GORDON W. STEWART

Executive EditorsW. RODNEY CLEMENT, JR. CATHERINE O'CONNOR

C. DREW DEMARAY PAMELA L. RYAN

Note &THOMAS J. EGAN, JR.

JOHN P. FISHWICK, JR.LEIGH ANN GALBRAITH

THOMAS G. GRUENERTPAMELA A. HASENSTEIN

Comment EditorsWILLIAM L. HIGGS

MICHAEL L. KRANCERALAN B. MUNRO

H. DAVID NATKINMELVIN T. RATTRAY

StaffROBIN JACKSON ALLEN JOHN R. MINCHEWFREDERICK W. BOGDAN ROBERT C. MOOT, JR.

JOHN L. CARPENTER KEVIN ALFRED NELSONW. GREGORY CONWAY H. JANE NORTH

W. GERARD FALLON, JR. CLAIRE ELIZABETH PANCERZMICHAEL J. FARR ROBERT S. PARKER

DAVID KEITH FRIEDFELD BONNIE L. PAULBARRY J. GAINEY JAMES FITZSIMMONS POWERS

MICHELLE L. GILBERT LAURIE A. RACHFORDTERRENCE L. GOODMAN JOY MALLICK RATTRAY

DAVID S. KEMPERS PATRICIA A. REEDPAUL J. KENNEDY DANIEL E. RILEY

TIMOTHY J. KILGALLON ELIZABETH A. RYANKATHERINE CARRUTH LINK ANDREW T. SANDERS, JR.

THEODORE F. LOPER JAMES D. SIMPSON, JR.PETER MALLORY WILLIAM R. SPALDING

BENTON J. MATHIS, JR. DONA A. SZAKMARY TERESA MILLER ALFRED PITTMAN TIBBETTS

MARY PATRICIA WALTHER

Faculty AdvisorROGER D. GROOT

FACULTY-SCHOOL OF LAW

JOHN D. WILSON, B.A., M.A., Ph.D., President of the UniversityROy L. STEINHEIMER, JR., A.B., J.D., Dean and Professor of LawCHARLES VAILL LAUGHLIN, A.B., LL.B., LL.M., S.J.D., Professor EmeritusEDWARD 0. HENNEMAN, B.A., J.D., Assistant Dean and Assistant Professor ofLawROBER D. GROOT, B.A., J.D., Professor LawROBERT E.R. HUNTLEY, A.B., LL.B., LL.M., Professor of LawFREDERIC L. KIRGIS, JR., B.A., LL.B., Professor of Law and Director of the

Frances Lewis Law CenterLEWIS H. LARUE, A.B., LL.B., Professor of LawANDREW W. McTHENIA, JR., A.B., M.A., LL.B., Professor of LawJ. TIMOTHY PHILIPPS, B.S., J.D., LL.M., Professor of LawWILFRED J. RITZ, A.B., LL.B., LL.M., S.J.D., Professor of LawTHOMAS L. SHAFFER, B.A., J.D., Professor of LawJAMES W.H. STEWART, B.A., J.D., Professor of LawJOSEPH E. ULRICH, A.B., LL.B., Professor of LawDENIS J. BRION, B.S., J.D., Associate Professor of LawSAMUEL W. CALHOUN, B.A, J.D., Associate Professor of LawMARK H. GRUNEWALD, B.A., J.D., Associate Professor of LawJAMES M. PHEMISTER, B.S., J.D., Associate Professor of LawWILLIAM S. GEIMER, B.S., J.D., Assistant Professor of LawSTEVEN H. HOBBS, B.A., J.D., Assistant Professor of LawTONI MARIE MASSARO, B.S., J.D., Assistant Professor of LawBRIAN CAMERON MURCHISON, B.A., J.D., Assistant Professor of LawSAMUEL E. STUMPF, JR., B.A., J.D., Assistant Professor of LawSARAH K. WIANT, B.A., M.L.S., J.D.,Law Librarian and Assistant Professor ofLawRUDOLPH BUMGARDNER, III, A.B., LL.B., Adjunct Professor of LawROBERT M. CAMPBELL, A.B., LL.B., Adjunct Professor of LawCLARK R. MOLLENHOFF, J.D., Adjunct Professor of LawRICHARD W. NELSON, B.A., M.A., J.D., Adjunct Professor of LawWILLIAM W. SWEENEY, A.B., LL.B., Adjunct Professor of LawROBERT C. WOOD, III, B.A., LL.B., Adjunct Professor of LawHENRY L. WOODWARD, A.B., LL.B., Adjunct Professor of LawRoss D. YOUNG, JR., LL.B., Adjunct Professor of LawHAROLD J. BERMAN, B.A., M.A., LL.B., Frances Lewis Scholar in Residence